Real Estate "Profits" and How I Stack Up

Here's an article from CNN Money that hits a few buttons for me.

• First, it's about real estate investing.
• Second, it lists the "best" markets to become a landlord. I thought I'd compare my results with the best.
• Third, it highlights (again) how little the mainstream media understands financial terms, what they mean, how to use them, and so forth.

Let's begin with the financial terms.

The article talks about "profits" and "average returns" in real estate investing. Both of these terms are "net" amounts -- what you have left over after expenses. For instance, a profit is generated when you earn revenue and then subtract expenses. What's left over is "profit". The same goes for investment returns. You take your net gain (income less expenses) and divide it by the amount invested to get your return percentage.

But in this article the author does not take into account investing costs. He simply takes revenue, divides it by the selling price of a unit (amount invested), and calls that "profit" and calculates "average return."

In the real world, profit and average return are calculated after expenses. Yes, some mutual funds publish their "returns" before expenses (or at least they used to), but we all know those aren't real returns until costs are deducted. The case is the same here. I'm not sure if the author doesn't know the difference or is simply ignoring it. Whatever the case, it makes him look like he doesn't know what he's talking about (at least to an informed reader.)

That said, the chart gets one term correct in calling it "gross rental yield" (GRY). And I admit that there is some value in calculating GRY. But it's certainly not "profit" or "average return." Not even close. You MUST deduct expenses to get those numbers. Believe me, I wish GRY was the same as profit and that's what we all took home to the bank! :)

Ok, with that rant out of the way, let's look at their top markets. The list of cities, gross rental yield, average monthly rent, and average unit selling price are as follows:

• Anderson, S.C. -- 15.3% -- $893 -- $69,900
• Greenville, S.C. -- 13% -- $975 -- $90,000
• Sioux City, Iowa -- 13% -- $914 -- $84,250
• Gainesville, Fla. -- 12% -- $1,161 -- $115,950
• Washington, D.C./Arlington, Va. -- 11.9% -- $1,966 -- $199,000
• Columbia, S.C. -- 11.3% -- $1,046 -- $111,500
• Pittsburgh, Pa. -- 11.3% -- $991 -- $105,700
• Charleston, S.C. -- 10% -- $1,160 -- $139,900
• Columbus, Ohio -- 10% -- $1,039 -- $125,000
• Omaha, Neb. -- 9.9% -- $1,059 -- $128,000

Just so we're all on the same page, here’s how you read the numbers using Anderson, S.C. as an example:

• Anderson's average rental unit sells for $69,900
• The average unit there generates $893 per month in rent (gross, no expenses deducted)
• This means the average rental unit generates $10,716 each year in gross rents ($893 * 12 months)
• The gross rental yield is therefore $10,716/$69,900 or 15.3%

Now, here's how I stack up to that:

• The total costs of my units (includes both purchase price and remodeling costs): $579,342
• Gross monthly rents of these units: $10,890
• Gross annual rents of these units: $130,680
• Gross rental yield: 22.6%

A few comments on this:

• I wish I was earning 22.6% profit on these units. I'm going to be between 8% and 11% when it all shakes out (which should be this fall as my last unit is done with its remodel, it's filled, and I get to a point where I'm through investing big in remodeling).
• I paid for all my units in cash, but my return would be higher if I leveraged my places, as I noted on each property write up I've done on FMF.
• There's no accounting for appreciation in these numbers.
• One thing that helped me out big-time is that I bought my places near the bottom of the market (not at the bottom, but near it, just as they turned up a bit. If I had started two years earlier I'd probably have double the properties now and be looking at HUGE gains.) Unfortunately, those days are mostly over.
• My numbers are against the averages in a market, so it's not really a fair comparison. I'd like it better if I knew what the top 10% or top 25% were earning so I could compare myself with their results.

Well, that's it for now. I will give you a detailed update on my rental units once the smoke clears.

I'd be interested in hearing from those out there who own rental places. What do you think of the article? How do your results compare to those in the cities highlighted?

Comments

[Mrs. PoP]

We bought our rental duplex at the bottom of the market in Florida - $50K + $5K to get it in rentable condition. It currently grosses $1550/mo, so that gives a GRY of 34%. Sounds amazing, and I'm definitely not complaining, but there are significant costs involved too, so gross is not anywhere close to profit even in our case where we manage our own units.

[SJ]

I've been looking and can't seem to find anything better than a 10% GRY in my area that didn't seem like a dump so havent seen a good reason to pull the trigger on anything.

And yeah, GRY doesn't mean a whole lot...One of the townhouses I looked at seemed decent until I saw the price of the homeowners assoc fees involved...huge relative expense that when combined with the property tax didn't leave much left over to actually maintain the property with...

[Erik]

The hard part is that this calculation only works when you first buy a place or are evaluating a purchase. If you buy a place for 100k and add 50k but then it is immediately worth 200k what do you use for gross rental yield? For the first year you could use 150k but what about 5 years later when the rents have gone up and your properties have appreciated. If your property is now worth 300k your yields against current rent won't be nearly as good. This is actually something I thought about a lot before buying properties. If the rental yield goes down based on appreciation, even if my out of pocket costs haven't changed does that mean I should sell the place?

@FMF - Could you do your calculation again with what you think fair market value is for the properties now?

I bought my properties from 2004 - 2008. I bought them for 465k and I estimate they are worth 550k. My gross rents are 46.5k or 8.5% of the current value of my properties. My rents haven't gone up as quickly as appreciation so I estimate that my original values were between 9-10%.

As you have stated, real estate investing is great for 'passive' income. If my yield goes down I'll likely still keep the places but at some point if the return ever got really low then I would have to consider selling and putting that money somewhere else. In today's low yielding environment, I am not even close to worrying about that.

[Maverick]

Yeah, these are "gross" percentage returns. I'd like to also see comparisons of RE "profits" (after expenses) compared to the Vanguard REIT sector fund returns. This way, one could compare the active vs passive returns. I continue to seek the highest total returns. Whenever I speak with friends who have rentals I'm still not convinced the active mgmt of rentals is worth it on a total return basis as they can't seem to identify the total return on a percentage basis after expenses.

[Erik]

Gross rental yields don't consider important factors such as does the property have a high HOA fee? What are the taxes and insurance?

My properties average 18k for taxes, insurance, fees (HOA, accountant), and repairs. I also average 7% vacancy so that is another 3.2k in average lost rent. 46.5 gross minus 21.2 expenses yields 25.3k in net. This assumes all properties are 100% paid off. In my case only two are paid off but that makes is even more complicated.

My expected net yield when all are paid off is 25.3/550 or 4.6%. That doesn't sound great but it doesn't account for appreciation or the tax advantages. (Yes, my yield is higher now with some leverage.) If you assume that properties will on average rise with inflation, then you are getting 4.6% over inflation with favorable tax provisions.

[Mike H]

Those are some really great yields, FMF. Well done.

The condo we have bought in 2005 for about $180k we are renting out for $13.2k a year or 7.3%, after expenses this yield is more like 6.4%. It has appreciated in value, being close to $300K now so if someone were to buy now the yields would be just under 4% which is pretty bad.

-Mike

[M-19]

I agree with the folks who think that the proper way to value an investment yield or return is by using the up-to-date current value (not the purchase price). Better yet-- use the value left to re-invest after selling costs.

The way I look at it is that if you bought it for $100K but it is worth $200K after selling costs (if you sold today)-- you have $200K of value tied up and you have the option to sell it and re-invest the $200K.

If you can get a better return on your $200K elsewhere on a similar investment-- you should do so.

The truth of the matter is that because:

1. cash flow from real estate is not consistent or predictable month to month like a CD for instance ( some months have repairs, taxes, or emergencies and others do not), and

2 the timeframe of the investment is unknown until the investor decides to sell-

....the best way to evaluate a return on a real estate investment is by using an IRR ( internal rate of return) calculation. Using this tool you get a true look at your overall yield accounting for both the variations in cashflow and the time value of money. You can get a solid IRR looking backwards using actual numbers obviously-- but you must use solid estimates and assumptions going forward. Using well thought out and researched estimations and assumptions is crucial. We usually get hard numbers for past expenses from the Seller's tax returns.

IRR is a very sensitive metric and it is possible that the longer you hold an investment the LOWER the IRR will be ( even if rents are increasing). This is basically because of the powerful effect of the time value of money component.

In my real estate dealings ( large commercial properties)
we even consider IRR as a useful guide of when to sell. We often find figuring out when to sell is often a tougher issue than figuring what and when to buy.

[OTC]

Real estate has various strategies that can be effective at providing strong returns.
When considering rental properties though, I think cash flow is the most important variable. Appreciation is merely icing on the cake. Also, it may be helpful to treat rental more like a business than an investment. I have monthly expenses that definitely eat into my gross rents. I try to leave myself enough room between rental income and expenses to navigate the ups and downs.
My rentals when 100% full yield $17.2K and my expenses are $4.8k for debt, $1k management, $1.9k taxes and insurance, $3k late payers, repairs, etc.. That leaves about $6500 monthly NOI. My goal is to be able to retire at 45. Cash flow is the vehicle that I would to get me there.

[OTC]

Real estate has various strategies that can be effective at providing strong returns.
When considering rental properties though, I think cash flow is the most important variable. Appreciation is merely icing on the cake. Also, it may be helpful to treat rental more like a business than an investment. I have monthly expenses that definitely eat into my gross rents. I try to leave myself enough room between rental income and expenses to navigate the ups and downs.
My rentals when 100% full yield $17.2K and my expenses are $4.8k for debt, $1k management, $1.9k taxes and insurance, $3k late payers, repairs, etc.. That leaves about $6500 monthly NOI. My goal is to be able to retire at 45. Cash flow is the vehicle that I would to get me there.

[Old Limey]

The prices of rentals in the states referenced are amazingly low compared with Silicon Valley, CA. Here you get to pay a minimum of $600K for a small home built in the 50's and 60's, and quite a bit more if it has been fixed up.
The lowest possible rent for a small apartment is $2,000/month. I don't see any new homes being built at all. The only new construction seems to be large developments of 4 & 5 story condos.

[Biere]

OTC what is your NOI goal? $6500/mo is strong and could easily retire assuming you don't live in Silicon Valley

[Joe]

The problem is that it's just so dependent on location. In Portland, it's pretty much impossible to make money right now. The price is just too high. I guess we can buy out of town, but then it'll hard to manage.

[OTC]

Biere,
My goal is 10k for the short term. My w2 income is about 6.5k - 7k when adding benefits. My main goal is to meet my w2 income so that I am not dependent on my job. I want to work jobs solely because I "like" them or find purpose in the job. I also set a goal to be able to retire at 40. However, I'm facing a possible divorce so this could all change.

[Matt]

Cannot believe they failed to mention Memphis, TN. Almost all Rental RE people I know have this as a top 3 market. Also Little Rock, AR

[OTC]

You right about Memphis... I'm in Tennessee too.